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May 6, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View

Stiglitz and Rogoff on Europe's Financial Troubles

Posted: 06 May 2010 01:26 AM PDT

Here are two views of the situation in Europe. First, Joseph Stiglitz isn't sure the euro can survive, or that it should:

Can the Euro be Saved?, by Joseph E. Stiglitz, Commentary, Project Syndicate: The Greek financial crisis has put the very survival of the euro at stake. At the euro's creation, many worried about its long-run viability. When everything went well, these worries were forgotten. But the question of how adjustments would be made if part of the eurozone were hit by a strong adverse shock lingered. Fixing the exchange rate and delegating monetary policy to the European Central Bank eliminated two primary means by which national governments stimulate their economies to avoid recession. What could replace them? ...
Some hoped that the Greek tragedy would convince policymakers that the euro cannot succeed without greater cooperation (including fiscal assistance). But Germany (and its Constitutional Court), partly following popular opinion, has opposed giving Greece the help that it needs. ...
For the EU's smaller countries, the lesson is clear: if they do not reduce their budget deficits, there is a high risk of a speculative attack, with little hope for adequate assistance from their neighbors, at least not without painful and counterproductive pro-cyclical budgetary restraints. As European countries take these measures, their economies are likely to weaken – with unhappy consequences for the global recovery. ...
The social and economic consequences of the current arrangements should be unacceptable. Those countries whose deficits have soared as a result of the global recession should not be forced into a death spiral – as Argentina was a decade ago.
One proposed solution is for these countries to engineer the equivalent of a devaluation – a uniform decrease in wages. This, I believe, is unachievable, and its distributive consequences are unacceptable. The social tensions would be enormous. It is a fantasy.
There is a second solution: the exit of Germany from the eurozone or the division of the eurozone into two sub-regions. The euro was an interesting experiment, but ... it lacks the institutional support required to make it work.
There is a third solution, which Europe may come to realize is the most promising for all: implement the institutional reforms, including the necessary fiscal framework, that should have been made when the euro was launched.
It is not too late for Europe to implement these reforms and thus live up to the ideals, based on solidarity, that underlay the euro's creation. But if Europe cannot do so, then perhaps it is better to admit failure and move on than to extract a high price in unemployment and human suffering in the name of a flawed economic model.

Next, Kenneth Rogoff on whether Greece and other countries will eventually default:

Europe finds the old rules still apply, by Kenneth Rogoff , Commentary, Financial Times: ...A recurring theme of my academic research with Carmen Reinhart is that "graduation" from emerging market status is a long, painful process that can take 75 years or more to complete. ...
The eurozone experiment was, in effect, an attempt to speed up the graduation process through the carrot of the single currency and the stick of harsher bail-out rules. Instead of having to demonstrate fortitude and commitment through decades of surpluses and declining public debt levels (as for example, Chile has done), euro members were allowed to have their cake and eat it, too. ... Greece could run up its public debt to more than 115 per cent of GDP. Even more stunning a figure is Greece's total external debt to GDP, which is more than 170 per cent, counting both public and private debt. Prof Reinhart and I find that most emerging markets run into trouble at external debt levels of merely 60 per cent of GDP. ...
Is it realistic for the IMF and Europe to hope that Greece (and other struggling euro members) will survive without an eventual default? ... Unfortunately, "near misses" are the exception, not the rule. ...
Will Europe's crisis end only in "near misses" rather than outright defaults or reschedulings? The answer involves a range of political, social and economic questions that are not easily quantifiable. ... It is very rare for a country to default because it literally cannot pay. In most cases, and certainly in southern Europe today, the issue is willingness to pay. ...
In the case of Europe, the decision to repay involves not only the usual costs and benefits, but also the added question of how a nation's status in the European Union will be affected. Is Europe prepared to go to great pains to punish Greece if it defaults, imposing costs much higher than those a non-euro country would face? If not, how can it seriously expect Greece to pay down debt levels far in excess of those navigated by almost any other large emerging market?
In our book on financial history, Prof Reinhart and I find that international banking crises are almost invariably followed by sovereign debt crises. Will the euro prove to be a firewall against this process, or a debt machine that fuels it? It is going to be extremely difficult for some of the peripheral eurozone economies to escape without large-scale defaults on their massive private external debts, public external debts, or both.

links for 2010-05-05

Posted: 05 May 2010 11:01 PM PDT

Galbraith: The Role of Fraud in the Financial Crisis

Posted: 05 May 2010 11:07 AM PDT

Recent testimony from Jamie Galbraith before the Subcommittee on Crime on the role that fraud played in the financial crisis:

Statement by James K. Galbraith, Lloyd M. Bentsen, jr. Chair in Government/Business Relations, Lyndon B. Johnson School of Public Affairs, The University of Texas at Austin, before the Subcommittee on Crime, Senate Judiciary Committee, May 4, 2010: Chairman Specter, Ranking Member Graham, Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.
I write to you from a disgraced profession. Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including "rational expectations," "market discipline," and the "efficient markets hypothesis" led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on, and that widespread fraud therefore could not occur. Not all economists believed this – but most did.
Thus the study of financial fraud received little attention. Practically no research institutes exist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft- pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the bubble. They continue to do so now. At a conference sponsored by the Levy Economics Institute in New York on April 17, the closest a former Under Secretary of the Treasury, Peter Fisher, got to this question was to use the word "naughtiness." This was on the day that the SEC charged Goldman Sachs with fraud.
There are exceptions. A famous 1993 article entitled "Looting: Bankruptcy for Profit," by George Akerlof and Paul Romer, drew exceptionally on the experience of regulators who understood fraud. The criminologist-economist William K. Black of the University of Missouri-Kansas City is our leading systematic analyst of the relationship between financial crime and financial crisis. Black points out that accounting fraud is a sure thing when you can control the institution engaging in it: "the best way to rob a bank is to own one." The experience of the Savings and Loan crisis was of businesses taken over for the explicit purpose of stripping them, of bleeding them dry. This was established in court: there were over one thousand felony convictions in the wake of that debacle. Other useful chronicles of modern financial fraud include James Stewart's Den of Thieves on the Boesky-Milken era and Kurt Eichenwald's Conspiracy of Fools, on the Enron scandal. Yet a large gap between this history and formal analysis remains.
Formal analysis tells us that control frauds follow certain patterns. They grow rapidly, reporting high profitability, certified by top accounting firms. They pay exceedingly well. At the same time, they radically lower standards, building new businesses in markets previously considered too risky for honest business. In the financial sector, this takes the form of relaxed – no, gutted – underwriting, combined with the capacity to pass the bad penny to the greater fool. In California in the 1980s, Charles Keating realized that an S&L charter was a "license to steal." In the 2000s, sub-prime mortgage origination was much the same thing. Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.
The complexity of the mortgage finance sector before the crisis highlights another characteristic marker of fraud. In the system that developed, the original mortgage documents lay buried – where they remain – in the records of the loan originators, many of them since defunct or taken over. Those records, if examined, would reveal the extent of missing documentation, of abusive practices, and of fraud. So far, we have only very limited evidence on this, notably a 2007 Fitch Ratings study of a very small sample of highly-rated RMBS, which found "fraud, abuse or missing documentation in virtually every file." An efforts a year ago by Representative Doggett to persuade Secretary Geithner to examine and report thoroughly on the extent of fraud in the underlying mortgage records received an epic run-around.
When sub-prime mortgages were bundled and securitized, the ratings agencies failed to examine the underlying loan quality. Instead they substituted statistical models, in order to generate ratings that would make the resulting RMBS acceptable to investors. When one assumes that prices will always rise, it follows that a loan secured by the asset can always be refinanced; therefore the actual condition of the borrower does not matter. That projection is, of course, only as good as the underlying assumption, but in this perversely-designed marketplace those who paid for ratings had no reason to care about the quality of assumptions. Meanwhile, mortgage originators now had a formula for extending loans to the worst borrowers they could find, secure that in this reverse Lake Wobegon no child would be deemed below average even though they all were. Credit quality collapsed because the system was designed for it to collapse.
A third element in the toxic brew was a simulacrum of "insurance," provided by the market in credit default swaps. These are doomsday instruments in a precise sense: they generate cash-flow for the issuer until the credit event occurs. If the event is large enough, the issuer then fails, at which point the government faces blackmail: it must either step in or the system will collapse. CDS spread the consequences of a housing-price downturn through the entire financial sector, across the globe. They also provided the means to short the market in residential mortgage-backed securities, so that the largest players could turn tail and bet against the instruments they had previously been selling, just before the house of cards crashed.
Latter-day financial economics is blind to all of this. It necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?
An older strand of institutional economics understood that a security is a contract in law. It can only be as good as the legal system that stands behind it. Some fraud is inevitable, but in a functioning system it must be rare. It must be considered – and rightly – a minor problem. If fraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails to respond with appropriate force, the legal system itself.
Control frauds always fail in the end. But the failure of the firm does not mean the fraud fails: the perpetrators often walk away rich. At some point, this requires subverting, suborning or defeating the law. This is where crime and politics intersect. At its heart, therefore, the financial crisis was a breakdown in the rule of law in America.
Ask yourselves: is it possible for mortgage originators, ratings agencies, underwriters, insurers and supervising agencies NOT to have known that the system of housing finance had become infested with fraud? Every statistical indicator of fraudulent practice – growth and profitability – suggests otherwise. Every examination of the record so far suggests otherwise. The very language in use: "liars' loans," "ninja loans," "neutron loans," and "toxic waste," tells you that people knew. I have also heard the expression, "IBG,YBG;" the meaning of that bit of code was: "I'll be gone, you'll be gone."
If doubt remains, investigation into the internal communications of the firms and agencies in question can clear it up. Emails are revealing. The government already possesses critical documentary trails -- those of AIG, Fannie Mae and Freddie Mac, the Treasury Department and the Federal Reserve. Those documents should be investigated, in full, by competent authority and also released, as appropriate, to the public. For instance, did AIG knowingly issue CDS against instruments that Goldman had designed on behalf of Mr. John Paulson to fail? If so, why? Or again: Did Fannie Mae and Freddie Mac appreciate the poor quality of the RMBS they were acquiring? Did they do so under pressure from Mr. Henry Paulson? If so, did Secretary Paulson know? And if he did, why did he act as he did? In a recent paper, Thomas Ferguson and Robert Johnson argue that the "Paulson Put" was intended to delay an inevitable crisis past the election. Does the internal record support this view?
Let us suppose that the investigation that you are about to begin confirms the existence of pervasive fraud, involving millions of mortgages, thousands of appraisers, underwriters, analysts, and the executives of the companies in which they worked, as well as public officials who assisted by turning a Nelson's Eye. What is the appropriate response?
Some appear to believe that "confidence in the banks" can be rebuilt by a new round of good economic news, by rising stock prices, by the reassurances of high officials – and by not looking too closely at the underlying evidence of fraud, abuse, deception and deceit. As you pursue your investigations, you will undermine, and I believe you may destroy, that illusion.
But you have to act. The true alternative is a failure extending over time from the economic to the political system. Just as too few predicted the financial crisis, it may be that too few are today speaking frankly about where a failure to deal with the aftermath may lead.
In this situation, let me suggest, the country faces an existential threat. Either the legal system must do its work. Or the market system cannot be restored. There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power of the law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case. Thank you.

"Automatic Stabilizers Work, Always and Everywhere"

Posted: 05 May 2010 09:09 AM PDT

One of the lessons of this recession is that fiscal policy is a very imperfect policy tool. In deep recessions when monetary policy has run its course -- when moving interest rates all the way to zero and trying non-traditional policies has not fixed the problem -- fiscal policy can provide the needed boost to aggregate demand. But the politics surrounding fiscal policy means it will be put into place far too late, if it is put into place at all, there will be fights over how to structure the stimulus, e.g. tax cuts versus government spending and the compromise may not be good policy, and there is no guarantee at all that the policies will be paid for when times improve (which undermines the policy the next time politicians promise it will be "temporary")..

One option would be to create a Fed-like structure responsible for fiscal policy, an agency that has a reasonable degree of independence from Congress and the administration. This agency would be required to be in balance its budget over, say, a ten year period, but could run surpluses or deficits in the interim as needed to manage the economy (it could have a list of ready to go infrastructure projects, use tax changes, etc.). So it could not change the average level of spending, that would still be determined by Congress, but it could shift that spending around as needed. But a proposal like this would never, ever make it through Congress, and even if it did I'm not sure I could support such an institution.

So what to do? One answer is automatic stabilizers such as social insurance programs that kick in when things get bad and turn off automatically when things get better. These worked well during the current recession, but by themselves weren't large enough to provide the needed stimulus. So more automatic stabilization is needed. When these policies are set in advance, and implemented down the road when the next recession hits, it avoids the political problems that plague discretionary policy. Congress doesn't have to do anything, and if their constituents don't like it, they can blame the program on their predecessors. And we don't have to limit ourselves to enhancing current programs, we could get much more creative with these stabilizers, e.g. payroll taxes that vary with the unemployment rate.

A harder problem is how to use automatic stabilizers to help to backfill the hole that recessions blow in state and local government budgets, but creative policies ought to be able to help here as well (however, the automatic nature of the help means that the policies must address potential gaming of the system -- states would have an incentive to make their budgets look bad in recessions -- but cost-sharing and other mechanisms can help with this). I think it's particularly important to add an automatic mechanism that provides help to states since states can quickly undo attempts to stimulate the economy at the federal level as they cut spending or raise taxes to balance their budgets as required by law, and the political problems with providing help to states in real time are severe.

Unless we get better legislators, and a couple of hundred years of history says not to count on that, enhancing the automatic stabilizers may be our best bet going forward. There's considerable empirical evidence showing that they work, including this new evidence that automatic stabilizers work "always and everywhere":

Fiscal Policy and Macroeconomic Stability: Automatic Stabilizers Work, Always and Everywhere, by Xavier Debrun and Radhicka Kapoor, IMF Working paper: [Full Text]: Summary: The paper revisits the link between fiscal policy and macroeconomic stability. Two salient features of our analysis are (1) a systematic test for the government's ambivalent role as a shock absorber and a shock inducer—removing a downward bias present in existing estimates of the impact of automatic stabilizers—and (2) a broad sample of advanced and emerging market economies. Results provide strong support for the view that fiscal stabilization operates mainly through automatic stabilizers. ...

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